Production Theory

Learning outcomes

At the end of this session, you will be able to

▪ Discuss Production Function
▪ Outline Concepts of Cost Functions
▪ Summarize Concept of isoquants and isocosts
▪ Describe Short and Long run Production Function
▪ Compare Short and Long run Cost Function

2
 Basic Concepts of Production Theory

➢Production function
✓Maximum amount of output that can be produced from any specified set of
inputs, given existing technology
➢Technical efficiency
✓Achieved when maximum amount of output is produced with a given
combination of inputs
➢Economic efficiency
✓Achieved when firm is producing a given output at the lowest possible total
cost
 Basic Concepts of Production Theory
➢Inputs are considered variable or fixed depending on
how readily their usage can be changed
➢Variable input
✓An input for which the level of usage may be changed quite
readily
➢Fixed input
✓An input for which the level of usage cannot readily be changed,
and which must be paid even if no output is produced
➢Quasi-fixed input
✓An input employed in a fixed amount for any positive level of
output that need not be paid if output is zero
 Basic Concepts of Production Theory

➢Short run
✓At least one input is fixed
✓All changes in output achieved by changing usage of variable
inputs
➢Long run
✓All inputs are variable
✓Output changed by varying usage of all inputs
The Production Function
➢A production function shows the relationship between
the quantity of inputs used to produce a good and the
quantity of output of that good.
➢It can be represented by a table, equation, or graph.
➢Example 1: Q= F(Land, Labour)
✓Farmer Sunil grows Rice.
✓He has 4 acres of land.
✓He can hire as many workers as he wants
Short Run Production
➢In the short run, capital is fixed
✓Only changes in the variable labor input can change the level
of output
➢Short run production function

Q = f ( L,K ) = f ( L )
Example 1: Farmer Sunil’s Production Function
L
Q (Kgs
(no. of 3,000
of Rice)
workers)

Quantity of output
2,500

0 0 2,000
1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
8
 Marginal Product
➢If Sunil hires one more worker, his output rises by the
marginal product of labor.

➢The marginal product of any input is the increase in

output arising from an additional unit of that input,
holding all other inputs constant.
➢Example: ∆Q = change in output, ∆L = change in labor
➢Marginal product of labor (MPL) = ∆Q
∆L
EXAMPLE 1: MPL = Slope of Prod Function

L Q MPL
3,000 equals the
(no. of (Kgs MPL slope of the
workers) of Rice) 2,500

Quantity of output
production function.
0 0 2,000
Notice that
1000
1 1000 MPL diminishes
1,500
800 as L increases.
2 1800 1,000
600 This explains why
3 2400 500 production
the
400 function gets flatter
4 2800 0
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
10
Example 1: Total & Marginal Product

Number of KGs of Rice MPL

workers

1 2000 1800
2 3800 1600
3 5400 1800
4 7200 1800
5 9000
 Why MPL Is Important

➢When Farmer Sunil hires an extra worker,

✓his costs rise by the wage he pays the worker
✓his output rises by MPL

➢Comparing them helps Sunil decide whether he would

benefit from hiring the worker.
Total, Average, & Marginal Products of Labor, K = 2
Number of Total product (Q) Average product Marginal product
workers (L) (AP=Q/L) (MP=Q/L)
0 0 -- --
1 52 52 52
2 112 56 60
3 170 56.7 58
4 220 55 50
5 258 51.6 38
6 286 47.7 28
7 304 43.4 18
8 314 39.3 10
9 318 35.3 4
10 314 31.4 -4

8-13
 Total, Average & Marginal Product Curves
Q2

Q1 Total
product
Panel A
Q0

L0 L1 L2

Panel B

Average
product

L0 L1 L2
Marginal
8-15 product
Isoquant Curves
Analyzing the production function: Long run
Types of Isoquant Curves
Linear Isoquant Curve

➢Perfect substitutes – production with only capital or only labor or

through “n” number of combinations between these two factors
Right Angle Iso-quant Curve
➢This curve is also known as Leontief Iso-quant, input output isoquant
and is a right angled curve.
➢No substitution between the factors of production
➢According to this, there is only one method of production to produce
any one commodity
Kinked iso-quant Curve

➢Limited substitutability between the factors of production.

➢Kinked iso-quant curve is also known as activity analysis
programming iso-quant or linear programming iso-quant.
Convex Iso-quant Curve
➢Factors are substituted for each other but up to a certain extent.
➢This curve is smooth and convex to the origin
 Marginal Rate of Technical Substitution

The MRTS is the slope of an isoquant & measures the rate at which the
two inputs can be substituted for one another while maintaining a
constant level of output

K
MRTS = −
L
The minus sign is added to make MRTS a positive
number since K L , the slope of the isoquant, is
negative
PROPERTIES
3.Two Iso-Product Curves Never Cut Each Other
4. Higher Iso-Product Curves Represent Higher Level of Output
5. Isoquants Need Not be Parallel to Each Other
6. No Isoquant can Touch Either Axis
Two Iso-Product Curves Never Cut Each
Other
Higher Iso-Product Curves Represent
Higher Level of Output
Isoquants Need Not be Parallel to Each Other

The rate of substitution in different isoquant schedules need not be

necessarily equal.
Isoquants Need Not be Parallel to Each Other
No Isoquant can Touch Either Axis

If an isoquant touches X-axis, then the product is being produced with

the help of labour alone without using capital at all.
No Isoquant can Touch Either Axis
Marginal Rate of Technical Substitution
Table 7.8 Input Combinations

for Isoquant Q = 52

Combination L K

A 6 2

B 4 3

C 3 4

D 2 6

E 2 8
Returns to Scale

✓Is large scale production more efficient than small scale production for
a certain market?

✓Is a market better served by many small firms or a few large ones?
Returns to Scale
✓The returns to scale concept describes the relationship between scale
and efficiency.

✓The returns to scale concept is an inherently long run concept.

✓Increasing returns to scale : a production function for which any given

proportional change in all inputs leads to a more than proportional
change in output.
Returns to Scale
✓ Constant returns to scale : a production function for which a
proportional change in all inputs causes output to change by the same
proportion.

✓Decreasing returns to scale : a production function for which a

proportional change in all inputs causes a less than proportional
change in output.
 The Distinction between Diminishing Returns and
Decreasing Returns to Scale
✓Diminishing returns to scale is a short run concept that refers to the
case in which one input varies while all others are held fixed.

✓Decreasing returns to scale is a long run concept that refers to the case
in which all inputs are varied by the same proportion.
Economic Region of Production
✓Ridge Lines – are lines connecting the points where the marginal
product of an input is equal to zero in the isoquant map and forming
the boundary for the economic region of production

✓Economic Region of Production – is the range in an isoquant diagram

where both inputs have a positive marginal product. It lies inside the
ridge lines
Increasing returns to scale (beyond point b)
Returns to Scale Shown on the Isoquant Map
Economic Region of Production
✓There are certain combinations of inputs that the firm should not use
in the long run no matter how cheap they are (unless the firm is being
paid to use them)

✓ These input combinations are represented by the portion of an

isoquant curve that has a positive slope
Economic Region of Production
✓A positive sloped isoquant means that merely to maintain the same
level of production, the firm must use more of both inputs if it
increases its use of one of the inputs

✓The marginal product of one input is negative, and using more of that
input would actually cause output to fall unless more of the other input
were also employed.
Isocost Lines

➢Isocost lines show different combinations of inputs which give the

same cost
➢At the point where the isocost line meets the vertical axis, the quantity
of capital that can be purchased equals the total cost divided by the
monthly cost of a unit of capital is TC / r
➢Where the isocost line meets the horizontal axis, the quantity of labor
that can be purchased equals the total cost divided by the monthly cost
of a unit of labor è TC / w
➢The slope of the isocost line is given by Slope of isocost line
(TC/r)/(TC/w) = -w/r
Choice of Input Combinations

➢The profit maximizing firm wants to produce its chosen output at the
minimum cost è it tries to find the isocost closest to the origin that still
touches the chosen isoquant.

➢Isocost Line - is a line that shows the various combinations of two

inputs that can be bought for a given dollar cost.

➢The equation for an isocost line is: C =L. PL +K. PK

Long-Run Costs
➢Long-run total cost (LTC) for a given level of output is given by:
✓ LTC = wL* + rK*

✓ Where w & r are prices of labor & capital, respectively, & (L*,
K*) is the input combination on the expansion path that minimizes
the total cost of producing that output

9-43
Isocost Curves
Maximizing output for a given input
Expansion Path
✓If we imagine a set of isoquants representing each possible rate of output,
and given the relative cost of resources, we can then draw isocost lines to
determine the optimal combination of resources for producing each rate of
output
✓Expansion Path leads to Total Cost Curve
✓An expansion path is a long-run concept (because all inputs can change)
✓Each point on the expansion path represents a cost-minimizing combination
of inputs
✓Given input prices, each point represents a total cost of producing a given
level of output when the entrepreneur can choose any input combination he
or she want
Expansion Path
✓ If the relative prices of resources change, the least-cost resource
combination will also change
✓the firm’s expansion path will change
✓For example, if the price of labor increases, capital becomes relatively
less expensive
✓the efficient production of any given rate of output will therefore call
for less labor and more capital
Optimal Input Combination to Minimize Cost for Given Output
 Optimization & Cost
➢Expansion path gives the efficient (least-cost) input
combinations for every level of output

✓Derived for a specific set of input prices

✓Along expansion path, input-price ratio is constant &
equal to the marginal rate of technical substitution
Expansion Path